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Airlines and the Incredible Shrinking Hubs

Why are so many current and former hubs seeing cuts?

As the airline industry works its way through a decade preceded by bankruptcies across the industry, carriers are eager to begin cutting costs and streamlining networks. Looking through the past several years, it becomes clear where a major component of this will come from: network rightsizing and hub reduction.

Network consolidationComing off a record wave of mergers, the airline industry is eager to make full use of its cost-savings potential. When there were many competitors in the industry, airlines often operated near overlapping flights from nearby hubs. Additionally, having a lot of different airlines, each run by their own management team, made controlling total capacity far more difficult.

In 2008, we saw the merger of Delta Air Lines and Northwest Airlines, which created the current Delta Air Lines(NYSE:DAL). Two years later, another airline merger took the crown for the world's largest airline as United Airlines and Continental Airlines joined to form United Continental Holdings(NYSE:UAL).

Fairly soon after the merger, Delta began to reduce its operations at its Cincinnati Northern Kentucky hub, moving many of the flights to the former Northwest hub in Detroit. But not all former Northwest hubs grew after the merger: Memphis lost its hub status in 2013 along with much of its service as Delta found having a second hub so close to its massive Atlanta operations to be uneconomical.

The latest moveUnited Continental has been working to finish the merger integration process for more than three years now. Through much of this time, synergies were difficult to realize and even those that did get off the ground were often balanced out by one-time integration charges. But with the biggest obstacles out of the way, United Continental is preparing to show investors what it can do by further streamlining operations and avoiding one-time charges.

Like Delta, United Continental came to the realization that, as a merged airline, it had too many hubs. So last week, the airline made the announcement that it would dramatically shrink operations out of the former Continental Airlines hub in Cleveland.

In a letter to Cleveland's workers, United Continental CEO Jeff Smisek, said:

No city has been more supportive of its hub carrier, and no group of employees has been more dedicated to providing great service, but the demand for hub-level connecting flying through Cleveland simply isn't there. Ultimately, we can't create demand, but we do have a responsibility to react to it. We must make the right business decisions, even when those decisions are painful, so we can continue to compete effectively and invest appropriately in our business.

Ultimately, the shrinkage of Cleveland operations is not a big surprise. When United Airlines and Continental Airlines merged in 2010, an agreement with the Ohio Attorney General at the time, Richard Cordray, limited the levels of flight cuts United Continental could implement at the airport in the interest of protecting Cleveland's jobs. But, as time progressed, the airline would be given more room to cut flights if the airport continued to underperform. With the current performance levels at the airport and United Continental now being able to cut more flights, the current actions in Cleveland are not too surprising.

Another settlementAs the airline industry has consolidated, the merger between AMR and US Airways that formed American Airlines Group(NASDAQ:AAL) came under far more scrutiny than past megamergers. Although the lawsuit by the Department of Justice never went to trial, the settlement agreement obtained many of the things the DOJ and the plaintiff states were looking for.

Among the terms is a requirement for the new airline to use all of its commuter slots at Washington National Airport for service to small and mid-sized non-hub communities for the next five years. During this time, American Airlines Group should be evaluating performance for each route to determine which ones stick around after the five years are up.

Fortunately for the hubs now controlled by American Airlines Group, the hubs all appear to have an economic purpose in the network, increasing their chances of sticking around. The hubs of the old American Airlines all serve high volumes of passenger traffic and are a core part of the network. Former US Airways hubs also look to be a good fit as they are in areas where fees are often lower and their location allows American Airlines to direct flights while avoiding busier airports.

Network reorganizationLike any other for-profit corporation, airlines are designed to make money and therefore eager to cut unprofitable flights and make networks more efficient. Expect airlines to continue using this as a way to cut costs over the next several years; after all, cost cuts are a primary benefit of mergers.

Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines and has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, long January 2015 $30 calls on Delta Air Lines, long May 2014 $31 calls on American Airlines Group, and long January 2015 $17 calls on American Airlines Group. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Alexander MacLennan is a Fool contributor covering Industrials, Airlines, and Financial companies. He is always ready for a good growth or turnaround story and tries to find them before the market does.